Home equity is great for homeowners looking to take out a low interest plan. But, while it comes with a lot of opportunities, there are some dangers in using your home as collateral.
Owning a home has a lot of perks. You get to choose when to fix it up, how to paint and decorate it, and you're not at the mercy of a landlord. But there's an addition benefit to owning your own home--you can use your home equity to take out a loan.
You might have heard of HELOC loans - or home equity line of credit. Simply put, this is just loan secured by your home. We've written about them before, but there's a lot to know about home equity and how you can use it to secure different loans.
What is home equity?
Home equity is the current value of your home minus any outstanding loans (i.e. your mortgage).
Put another way, it's how much you truly own of your home. The rest is how much the bank owns (i.e. how much you took out for a mortgage). So your home equity increases as you pay off your mortage.
Home equity loan vs. home equity line of credit
Home equity loans and home equity lines of credit are two different loan options for homeowners.
This loan, which can be though of as a second mortgage, lets the borrower space out payments over a longth length of time. Depending on how much home equity you have, you can qualify for a large loan with a low interest rate, using your houses as collateral.
So why would you want this line of credit instead of a regular credit card? Well, you can get a much larger line of credit with your home equity. Yes, credit cards can offer lines of credit up to $15,000, but HELCOs can offer up to $50,000. Obviously, your credit history, equity, and income all factor into how much you'll receive.
Unlike home equity loans, however, HELCOs have variable interest rates. So while your initial rate might be low, it could easily fluctuate one way or the other due to macro-economic factors outside your control.
Which should you get?
If you're looking to finance a large project, have a set amount in mind, and don't plan on taking out another loan anytime soon, a home equity loan could be right for you. For example, if you're borrowing money to do more work on your home, it just makes sense to get a home equity loan.
Home equity loans also have longer borrowing period, with fixed interest rates, meaning you have a more structured payment plan.
As I mentioned above, a home equity line of credit is best for those who need a revolving line of credit over the course of a few years. There are a variety of reasons you could get a HELCO over a traditional line of credit. A few include:
Making improvements to your home
Like a home equity loan, borrowing money against your home and investing it back into fixing it up makes a lot of sense for fixer-uppers that need a bunch of small improvements - that way you could continue to borrow money when you need it.
Consolidating high interest cards
HELCOs have traditionally low interest rates for the credit worthy, so using a HELCO to pay off credit cards with interest rates like 15 or 20 percent can help you pay off debt quicker than, say, a balance transfer.
A back-up emergency fund
The great thing about HELCOs is that they're sort of like credit cards. The money is there when you need it, so having it in addition to an emergency fund just in case you're hit with a large, unexpected expense could be a life saver.
What kind of credit do you need to get a home equity loan?
Those with poor credit can get home equity loans (but should avoid HELCOs), but it's very important to know that your home is up as collateral if you can't pay back the lender. So obviously anyone who can't feasibly see themselves being able to pay back a loan in a timely manner should never take one out.
Also, if you have poor credit, or really anything less than perfect credit, you won't get the greatest interest rate on your loan - which is something to consider if you can't afford to pay back that interest quickly.
If you own more of your home than you owe on it, you'll definitely be seen as a lower-risk candidate. This means that the loan amount or line of credit you'll receive will be higher. That's another important reason to consider putting a 20 percent (or more) down payment on your home when you buy.
When should you NOT use your home equity to take out a loan?
While HELCOs and home equity loans are a great opportunity for homeowners, there are a few times when they should be avoided.
If you're planning on selling your house soon
If you're planning to move and you might not be able to pay off your loan or line of credit quickly, you might not want to take out a home equity loan. Before you move, all your debts on the house will need to paid off.
Remember the equation above? -your home minus your outstanding debts on the home. If you have a loan out on your house, you're driving down the home equity, which doesn't look good when you're trying to sell.
If you need a last-resort loan
It's important to reiterate that you're putting your home at risk by taking out either of these loans. If you can't pay back the lender, your house could be taken from you.
This is why you should stay away from home equity loans if you're hit with a serious financial burden, since there's a possibility you won't be able to pay it back right away.
If you have poor spending habits
I mentioned earlier that using a HELCO to pay off credit card debt can be a good idea. It could, but not if you don't address the reasons you got into debt in the first place. To truly get out of debt, you need to deal with your negative spending habits and come up with a way to avoid going into debt in the future.
Where to get home equity loans or lines of credit
The best place to start looking for a home equity loans or lines of credit is LendingTree. You can easily compare a handful of rates all in one place and see which one is best for you. At the time of writing, LendingTree has an APR as low as 3.24 percent for home equity loans.
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